Relationship between GDP and stock markets

When we talk about the growth of a country, the word GDP is always mentioned. In the aftermath of the covid pandemic, the GDP across many economies saw a reduction, and the ongoing war has further added fuel to this fire. While this reducing GDP in many countries is making the policymakers sweat and take serious measures to revive the economy, stock markets are singing a different story. Take the case of India, GDP in the country reduced significantly during the covid period but the stock markets rose to new heights. So what is the relationship between GDP and stock markets and what are the lessons to be learned, especially by retail investors? The answers to these questions are discussed hereunder. 

What is GDP?

GDP stands for Gross Domestic Product and is the most common yardstick to measure a country’s growth and the size of the economy. GDP accounts for the final value of all the goods and services manufactured or produced in a country during a specified period. The usual measure of such a period is a year or a quarter. The GDP figure also accounts for the final value of goods and services that the country exports and imports and the same are reduced from the GDP. In developing economies like India, the government’s contribution to public spending and creating infrastructure is high. Therefore, the same is also included in GDP calculation along with any investments made by corporations. 

The formula to calculate GDP is given below.

GDP = Value of final goods and services manufactured or produced in the country + Government spending + Capex Investments or Private Spending + Net Exports (Exports-Imports)

This cumulative figure is represented in absolute terms which are shown as the value of the economy as well as in terms of per capita GDP. The most widely used measure of GDP is when it is represented in terms of percentage which represents the year-on-year growth rate. 

Read More: The Signal: Reading into GDP numbers for 4th quarter of financial year 2022

What are stock markets?

Stock markets are the platform for buying and selling stocks and other derivative instruments on stock exchanges in the primary and secondary markets. The value of securities on the stock markets is affected by many factors and thereby the prices of stocks move in trends. 

How does GDP impact stock markets?

Stock markets and GDP are often seen as strong indicators of the state of the economy and influence each other. Traditionally speaking, stock markets and GDP were viewed to go in similar directions but in recent years we have seen that there is decreasing correlation between the two. 

When the world saw a recession in 2008, the stock markets across the globe plummeted and were gripped by bear markets. But recovery was seen in the GDP of the country in 2009-2011. The same was reflected in the stock markets too and they recovered for a short period before falling again due to a rise in crude oil prices and other factors like high inflation, the debt crisis in Europe, etc. This decrease in stock markets was again corroborated by a decrease in GDP. 

However, in recent years, especially post covid, the world collectively saw a decrease in GDP due to severe lockdowns across the world and other contributing factors like rising crude oil prices, breakdown in global supply chains, Russia – Ukraine war, etc. Major economies in the world are contracting and are about to face severe recession but stock markets in some of these countries are seeing an increase. Take the case of India, while the global economy giants are seeing a slow increase or decrease in their GDPs and volatile stock markets, GDP in India is slowly getting back to its pre-covid levels. The IMF is also of the view that India will largely remain unaffected by the global recession scare. The stock markets, on the other hand, are quite optimistic and are seeing bullish trends. 

This divergence of correlation between the GDP and stock markets can be explained as under. 

1. Various government schemes introduced by the government to provide stimulus to the manufacturing and production in the country as well as consumer spending have contributed to positive market sentiment although the growth in GDP is still slow.
2. The stock markets have a futuristic approach and bank on a long-term view of the economy. Therefore forward looking at the moment even though the GDP growth rate is lower.
3. Countries across the globe are facing high inflation and interest rates have been increased by many economies. This decrease in liquidity impacts consumer spending and purchasing power. However, the stock markets have more or less a bullish view backed by the positive annual and quarterly results of many corporate giants. This recovery is attributed to government measures and stimulus packages as well as the introduction of many schemes like PLI (Production Linked Incentive) Schemes.
4. The current FDI in the country is also a contributing factor to the increase in stock markets adding to the long-term view of an improving economy.

Conclusion

GDP is one of the prime factors that affect stock markets and investor sentiments. Though sometimes the market sentiments are quite diverse and remain more or less unaffected even in the face of a slowdown in GDP. However, this divergence in the stock markets and GDP growth rates are temporary and will correct itself in the long run. 

In such a scenario, either the GDP rate will go up or the stock markets will show a drastic reduction. While the probability of stock markets showing a drastic downtrend is lower, unless there is a major factor leading to bottoming stock markets, the probability of increasing the GDP rate is higher. Currently, investors can enjoy higher returns on their equity investments but if these show a downtrend, investors can bet on debt and gold investments to balance out their portfolio. Therefore having a diverse portfolio will help investors earn decent returns even if the GDP and stock markets are not in sync. 

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